The Taleb Conundrum

I first read Nassim Taleb’s story on the virtue of buying cheap options in 2000. It was a tough time for an option believer in those days in India. Out of my basement stint for an e-broker, which was struggling under startup pressures with “nobody seems to be interested in futures” statement emailed to me, Taleb inspired me at a critical time. Eight years, I still believe his cheap option strategy is virtuous, but there is a lot about Taleb’s random strategy that troubles me to the extent of challenging it. I have mentioned some of my disagreements prior, but the guru’s work deserves a serious debate.
First and foremost, Taleb makes no claims of being able to beat markets. What this means is that Taleb is not in the predictive business. His hedge fund Empirica was into hedging solutions and not into predictive forecasts. We at Orpheus are into the predictive business, but we also make no claims of beating the market. But there is a difference. There are many ways you can beat a market. You can either give more returns than DOW Jones or Sensex over a year. Or you catch every multi-week move that the DOW or Sensex might make over the year.
For example 2007 Sensex saw 6 major turns starting 07 Jan 2007 at 13,860, followed by an upmove to 14,538 on 11 Feb 2007, after which we saw a dip till 18 Mar 2007 till 12,430, from the week ending 18 Mar 2007 till 22 Jul 2007 Sensex pushed up till 15,565, a small dip followed till 19 Aug 2007 at 14,141 and then one way move above 20,000 till 13 Jan 2008. On a net basis though the Sensex moved up 50%, but on a gross basis markets move up 77% and down 23% in total six moves averaging 20% each.
A derivatives trader is not concerned about net yearly moves, but all tradable moves whether up or down. So beating the market would mean capturing the entire 101% gross move in Sensex for the year, a tall benchmark and a near impossible task to achieve. But capturing 50% of the net return of 2007 was easy for a buy and hold investor invested from 07 Jan 2007 till 13 Jan 2008. But this passive investor may have beaten the market in 2007, but the market is beating him in 2008 now that it’s down 28% for the year.
Beating the market hence is a misnomer, a jargon which does not mean anything. Any hedge fund that operated from 1975 till 2000 and caught the 1987 meltdown can claim to have beaten the market. It’s more about double digit or triple digit returns that suggest predictive knowledge and trading expertise. Like what Robert Prechter did when he made 444% in a three-month monitored options trading account. Just like many traders do, day in and day out, some survive and some shine. But then trading itself is a hard task, you can actively trade from the age of 26 to 45, like what Taleb did, but then market cycle overtakes the human cycle, the very reason we continue to live the illusion of beating the yearly return of a market and not some supernormal or triple digit returns. Taleb’s philosophy is not for the traders who want to beat the markets and want to make triple digit returns. Taleb’s 1987 jackpot was the one off event that he admits hit him from out of the blue and it had nothing to do with predictive value.
Second. His idea of Randomness is flawed. There is not one man who saw the 1987 crash (I know three of them), or one trader who saw the 2000 tech bubble bust, or one Goldman Sachs, which saw the subprime mess shorting opportunity, there were many who saw the real estate crash in the US. Randomness is for the masses. As they don’t understand how markets work. Markets are clock work and not random as Taleb claims. Forecasters have proved it, again and again, giving not only great calls but also timing them. There are technicians who timed a short call two days before Sep 11, and there are technicians who said after Sep 11 that markets should bottom anytime soon. In 21 trading days DOW hit the base and in 40 trading days markets were back above SEP 11 levels. Bill Sarubbi timed Gold for 2007. How can you time markets, if they are random?
Taleb’s hypothesis is weak and does not comprehend random events like earthquake and disasters that don’t affect the markets. Recent Chinese earthquake was all over the news, and the SSEC (Shanghai Index) went up for three days after the earthquake. Even the deadliest Tsunami, which killed more than 225,000 people in eleven countries, was followed by a rise in stock market valuations around the globe. The assassination of presidents and prime ministers are random events with poor correlation with market crashes. Market randomness is predictable and has nothing to do with event randomness, which may or may not influence the market. All that does influence the market is non-random in nature and is nonlinear mathematics, pure in its structure. The power law, fractals, cycles and sentiment measuring tools have high predictive power. And Black Swans have nothing to do why DOW goes up or down.
Third. Though recent broker inventiveness and rush for trading volumes have to lead to the mushrooming of a zillion leveraged products (example 1 to 100 leverage), classically options offered a protected leverage compared to Futures. No wonder the upside was unlimited compared to the downside. The only catch was that 85% of the Options generally expired worthless. And if you are just buying cheap options, volatility or chance will definitely make you rich on that black day like 1987. Volatility is cyclical and starting 2007 is moving up in a 25-year cycle which should top somewhere in mid-2015. This means that chances for buying cheap options are going to be few, but profitable.
Good forecasts cannot be subdued with randomness talk. And there are living legends like Richard Russell forecasting markets day after day starting 1958. Options are versatile instruments that can do better than waiting for that 1987 crash again. Being on the long side helps as option writing has an unlimited risk that can implode and cause more than a Barings’ failure.
What we have been doing is for you to judge. But early 02 Jun we gave you a JUN strangle strategy. Markets were at inflection points, with no clear supports and downward momentum pushed us to run with our negative broad market view. Barring CNXIT (Tech Index)
We are negative for every other market sector. The Strangle resulted in an 81 percent return without transaction costs. The illustrated chart highlights the decay in OTM call options, the fall of NIFTY over the last two trading weeks, the rise in OTM PUT option premiums and the resulting Strangle payoff premiums.
We still remain negative on the market. But considering prices have hit the previous iv wave supports for many of our covered indices, the early next week prices could attempt a sub-minor bounce. Markets might get choppy for a few days before turning down again, pushing lower. We will review any new strategies on Wednesday in our mid-week issue. Till then we hope we clarified a part of Taleb’s conundrum.